home tags Search Feed
Reggie prepares to throw a bomb into the investment banking crowd

Written by Reggie Middleton

Wednesday, 13 August 2008

Frank Quattrone, tech company investment banking extraordinaire, shares his views on Wall Street research - and I feel compelled to comment... See NYT article for the full spread (forgvie me NYT, for excerpting such a large chunk of the interview, but I must harp on this - my comments, as usual, are the red annotations):

Mr. Quattrone, dressed in his West Coast uniform — a blue blazer over a polo shirt and a pair of khakis — was almost finished with his presentation when, in response to a question from the audience, he shared his views about the state of Wall Street research, a topic that was once all the rage but now often goes overlooked.

“I do think the industry should petition to remove the Spitzer initiatives because ultimately they hurt the competitiveness of our country by denying small companies the access to research analysts,” he said, throwing a proverbial grenade into the auditorium.

Mr. Quattrone was referring, of course, to the former New York attorney general Eliot Spitzer’s landmark settlement in 2002, which forced the separation of investment banking from research. The settlement followed an investigation into whether some Wall Street analysts were providing misleading ratings of the companies they covered to bolster their firms’ investment banking business. Henry Blodget of Merrill Lynch and Jack Grubman of Citigroup were barred from the securities industry and others took their licks. (As an aside, Mr. Spitzer was not behind Mr. Quattrone’s prosecution.)

As a result, banks are no longer allowed to pay their analysts from any revenue derived from investment banking, only from trading operations. Beyond that, an investment banker can’t even call a research analyst at the same firm without a lawyer chaperoning the conversation. So what??? The confict of interest was real and damaging to the retail and instiutional investor alike. Hate Spitzer all you want, he was on point with this call.

At the time, the new rules had a certain undeniable appeal. Because research analysts so depended on investment banking work for their own bonuses — working on initial public offerings and mergers — they faced unquestionable conflicts.

... If Mr. Quattrone had his way, he would turn the clock back entirely. “I am not denying that there is the potential for conflict — always has been, always will be. I’m just questioning the best means of managing the conflict,” he told me after his presentation. “If the principles of what constitutes ethical and unethical behavior are spelled out clearly, such as disclosing the firms’ investment banking relationships and ownership interests in the covered security, as well as not publishing favorable reports on companies in which you do not believe — and violators are punished — the conflicts will be managed.” How do we determine what analysts do not truly beleive without full blown legal discovery, and then some??? It can't possibly be based on performance. Perforance was bad before Spitzer, and it was bad after Spitzer.

It’s widely known on Wall Street that because research can no longer count on investment banking revenue, research is expected to pay its own way. Many of the big banks have responded, to put it bluntly, by running their research departments more cheaply, or not running them at all. Prudential Financial, which had a pretty good research arm, decided to shut it down entirely last summer. This is because the Wall Street business model is not predidcated upon truth telling. I have had a deluge of RETAIL users (that's individual invetors with small budgets, not just the institutional guys) of my blog email me and some even comment publicly (see the comments in this post) that they would pay $5,000 per year to access my blog research and consider it a bargain. I don't thinks there is a regular reader on this blog that doesn't believe Reggie's research is top notch and best in class. Think long and hard about this, investment industry folk. That $5k number is probably more than twice the commissions generated by the average retail investor at Merrill Lynch. All you need to do is refine the product, fellas. If you really have a problem with it, contact me and I will private label my stuff over to you. I have 14 slots available, one for every big brokerage, plus a few for the smaller ones (we can even schedule a BoomBustBlog event around it ).

Many of the most talented analysts — and therefore the most expensive — have left the business. And the smart up-and-coming ones who saw the handwriting on the wall ran to the “buy side,” jumping into hedge funds, venture capital firms and private equity. Some ambitious analysts have tried to go the independent route, but nearly all of them will tell you it has been tough going. No argument here, but the reason is because high quality research has been devalued on the Street and the contemporary thinking is that in order to have quality research you have to generate it yourself. That is why I built my own team. Nobody really wants to go through all that trouble (or at least many people don't want to). All we really need is a competitive product. This is a prospetive client talking - me!

That has created a two-part dilemma. The first is that the quality of research on Wall Street these days, notwithstanding some great recent calls from the likes of Meredith Whitney of Oppenheimer and Richard Bove, an independent analyst, has deteriorated even further and is coming under greater pressure as more banks begin to outsource research functions. I don't know I think I have had some pretty great calls, as well. I'll post a quick pictorial at the end of the post.

It may be true that analysts now put a lot more sell ratings on stocks than they used to, clearly a result of Mr. Spitzer’s settlement. But sell ratings are only a small part of the story. Analysts were never supposed to be just stock pickers. Ask any big institutional investor about what makes good research analysts and the answer is rarely the buy, sell or hold ratings. And herein lies the problem. Buy, sell and hold calls may not make a good analyst but they can damn sure identify the bad ones - and the street is rife with them. Not necessarily bad in terms of ability (since I know many of these guys are quite bright) but bad in terms of actual performance. The conflicts and coporate politics bullsh1t is still there, trust me. How else can a lowly blogger such as myself outperform every analyst and brokerage house on the street??? It is the information they can provide, the details they model and understanding the nuance of the executives. Those aspects of research don’t always end up in reports, but that’s what separates the good analysts from the not-so-good.

The second problem — which is an even bigger one — is that it is hard to find good research on small companies. All the focus has moved to large companies where the big money is sloshing around. And that makes being a small public company a very difficult task, since nobody’s paying any attention to them. The reason no one is paying attention to them is because the investment banking money is not sloshing around them. It has abosutely, and I mean absilutely, nothing to do with their investment potential. Listen, all investors follow analysts for one reason and one reason only - greedy self interest. They want to make more money, or at least prevent the loss of the money they already have. This sounds worse than it is, since we are all in this to make money. There is absolutely nothing inherent in a small company that will prevent a potential investor from making money that is not inherent in a big company. Hey, now that I think of it, the first few guys in the door of a small company will actually make more money since there will most likely be a scarcity of shares and once the good news gets out thanks to one of those SUPERB anlalysts - BANG! Up shoots the stock. Remind me again, why is there a problem with analysts covering small companies... Oh Yeah! Small companies just don't have the capital requirements to garner the interests of transaction orientated investment banks. Operating and investment performance be damned!!!

“The only way that sell-side analysts now can make money inside of a big firm like that is to become an ‘Institutional Investor All-American’ research analyst,” Mr. Quattrone told me, “which means they have to cover the Microsofts and Googles. Why would they spend any of their time working with these small companies?” Mr. Quattrone posits that the lack of research has been one reason the initial public offering market for technology companies has had a tough time. How about if that analysit had a 8 year track record of 60% plus returns. Clients will follow him like the children did the Pied Piper. Why is it that pure performance takes the back seat to everything these days???

Mr. Quattrone compared Wall Street research with journalism. “Publications have journalists and editorial staff — kind of like research analysts — whom the public expects to be unbiased reporters of fact and opinion who report the truth and provide their honest opinion on important matters,” he said. “They also have a circulation department and an advertising department — kind of like institutional salespeople and bankers — who generate revenue. There is an inherent omnipresent potential conflict of interest between the journalists and the revenue generating departments because the latter produce the revenue that pay the former.” Or, in the case of journalists, editors, and writers that produce unique, rare and valuable product, people are glad to pay for it - which mollifies the issue.

Unfortunately, I cannot include charts for Bears Stearns, Countrywide, etc. since they are no longer in existance, but the chart patterns are similar to the one's above. These are all companies that I were bearsish on way before the "Street" said sell.

For those who haven't been by BoomBustBlog user Shaunsnoll's site, he has a spreadsheet that tracks this blog's research. Give it a try. I would suggest that Excel web queries be used to automatically update the stock prices, since it the data is dated.

Add this page to your favorite Social Bookmarking websites

Set as favorite

Bookmark

Email This

Trackback(0)

TrackBack URI for this entry

Comments (5) Add Comment

Subscribe to this comment's feed

...
written by Eric Benjamin, August 13, 2008

Hi Reggie,

I've enjoyed being a fly-on-the-wall on your blog for months. I particularly enjoy reading your sarcastically incisive posts - like this one.

But I think you may be preaching prematurely:

-You have made some very good calls - but they're correlated. You and lots of others identified the housing mess, and the impact it would have on banks, and started taking or publishing big bets against financial companies. For your sake I hope you've been richly rewarded in your private trading. But for a serious investor to take you and your analysis seriously he'd need to see something else: a history of non-correlated super-market returns.

-I certainly agree with your acerbic criticism of Quattrone for suggesting that the Spitzer rules be repealed. But if I may summarize your post as: "given all their resources, why can't the wall street analysts predict the market performance of companies any better?" the answer seems obvious: they are indirectly market participants - LARGE market participants. If all the analysts did better than the market...who would be losing? The "buy-side" mutual funds? Why? The buy-side is as-well capitalized (in $ and brainpower terms). In any competition there must be some winners and some losers. If you have unusual skill (and you may) you'd do better to start a closed-end mutual fund and charge your loyal followers "2-and-20".

...
written by Reggie Middleton, August 13, 2008

I don't want to sound like I'm boasting, but I have a very good track record of consistent supernormal returns dating back over 7 years. I simply started the blog last year. We all have bad years though, and I'm sure mine will be coming up sooner or later. I'm human just like the rest of the guys. As for correlation, my returns are uncorrleated to the market. The market is going down, my returns are going up. I think what you mean is returns that are consistent in up and down markets. Well, that is the goal, and thus far I have done a fairly decent job, but as I said earlier, we all have our days.

Let's put it this way, if I did have a fund that was charging 2 and 20, I would not be allowed to publicize it through this blog. It sounds like you are smart guy, so I am sure you can read between the lines.

In regards to the big banks, I don't believe their goals are maximum return for the client through their research department. That is the point that I was getting at. It is their client's that are the market (many buys side groups consume I bank research - for better or for worse), not the research departments themselves. Take notice that the IB proprietary trading desks have access to internal research and they almost always outperform the retail clients. Now why would that be?

...
written by Ed Ryan, August 14, 2008

Reggie,

Again, You Are The Man!

Now, regarding Eliot, who would have won the 2012 election if McCain won the 2008 election.

Eliot blew it. But was the only force fighting the friends of Frank, Henry B., and his like.

Now Frank Q. and Henry B. are now back as players and Eliot is toast.

The 'Street" rewards the villians and punishes the inocent as many entering retirement will see.

The few, the proud, and the brave, hopfully will lead us out of this mess.

Semper Fi, Reggie, lead on.

...
written by M Williamson, August 20, 2008

Reggie - I have been a lurker for several months. I appreciate your work.

As a former ibanker, I saw first hand the inherent conflict in the business model. Although, I would say that in any industry that sells a product or service, the salesmen have to tell the people to buy. That doesn't make it right, it just means that life is all about conflicts and we have to make decisions on our own. I am for people taking responsibility for their own actions.

It is difficult to point to one part of the system and deem them the bad guy. For instance, I could make an argument that the Fidos and Putnams of the world are equally at fault b/c they gave their blessing (ie allocated their money) to the deals which enabled them to go public. A deal never gets done solely on retail interest - in fact retail allocations rarely surpass 15%. Therefore, what I would deem to be the "true" gate keepers of the money let us all down because the money was too good...but that was true at all levels. Mgmt making up a story, ibankers selling a story, money managers buying a story, and finally retail investors buying a story all because they wanted to make money in the greatest casino of all time. Hell I love to get on a hot streak in Vegas, but I need take responsibility when that hot streak ends.

When money is flowing, regulation gets weaker/goes away. Follow the money and you can generally find your answer. Let's look at what happened post Spitzer at one of your faves - GS. 2001 Operating Income: Ibanking $719 MM, Prop Investing $1,215MM....2007 Ibanking $2,570MM, Prop Investing $13,228MM Hmmm....which area has grown the most? GS realized that risk/reward profile of the research analyst "conflict" with clients could be dwarfed by moving that conflict in house. It is simple math.

Your work on the financial sector reminds me of the pipeline cos circa Enron. Everyone wanted to believe that Enron was a roque operator and an anomoly -- that Duke, El Paso, et al didn't have the same off balance sheet shenanigans...yeah right. How long do you have to be alive to realize that if somebody in business is doing something and making money, it won't be long before everybody is doing it. The one thing I didn't think about at the time was that of course the ibanks/commercial banks structuring the deals for the energy companies where utilizing the same in house. Even dealers taste the product once in a while!

Keep up the good work.

...
written by Reggie Middleton, August 21, 2008

You make excellent points, and I agree. I don't intend to cast Ibanks as bad guys, just guys who willfully take advantage of retail (an instititional) clients via the research/sale/distribution channel thing. As you have accurately pointed out, this conflict is inherent in nearly all sales/distribution channels, the kicker is that very few of those channels actually tout themselves as having a bona fide advisory role with a "Chinese wall" between sales and advisory. In other words, the bullsh1t tends to run a little thinner in the used car salesman space than in the stock brokerage.